The Non-Qualified Annuity Stretch: Using Fixed Indexed Annuities

When a non-qualified annuity passes to a beneficiary, the biggest question is often not who receives it, but how fast the gain is taxed. A stretch lets a qualifying beneficiary take the money in payments over a lifetime instead of all at once, so the annuity can keep growing tax-deferred for decades. This explains how the stretch works, why a fixed indexed annuity is a natural fit, and what to confirm before relying on it.

The Short Version

A non-qualified annuity stretch means a non-spouse beneficiary takes required payments over his or her life expectancy, beginning within one year of the owner’s death, rather than taking a lump sum or emptying the account in five years. Only the payments are taxed each year, so the remaining balance can continue to grow tax-deferred.

What Is a Non-Qualified Annuity Stretch?

A non-qualified annuity is funded with after-tax money, not IRA or 401(k) dollars. Your original deposit is your cost basis and comes back tax-free. The growth above basis is taxed as ordinary income when it is paid out. Federal tax law, in IRC Section 72(s), sets the rules for what a beneficiary must do after the owner dies.

• The default: the entire contract must be paid out within five years of the owner’s death.
• The stretch exception: a designated individual beneficiary may instead take payments over his or her life expectancy, provided they begin within one year of death.
• A spouse has an extra option: continuing the contract as the new owner, with no payout required until later.

How the Stretch Works, Step by Step

1. The owner dies and the carrier is notified. The beneficiary submits a death certificate and claim paperwork. The clock for the one-year deadline starts on the date of death, not the date of the claim.

2. The beneficiary elects the stretch. Within one year of death, the beneficiary elects life-expectancy payments instead of a lump sum or the five-year payout. Missing the deadline generally means the five-year rule applies.

3. Payments are set by a life-expectancy factor. Each year’s required payment is the contract balance divided by the remaining life-expectancy factor, so the amount adjusts as the balance changes.

4. The balance remaining stays in the contract. Money that has not yet been paid out stays tax-deferred. Many carriers also allow extra withdrawals beyond the required amount.

The Stretch Versus Other Ways to Take It

Why a Fixed Indexed Annuity Fits the Stretch

A stretch only works as well as the contract that holds the money for the next 30 to 50 years. A fixed indexed annuity, often called an FIA, is an insurance contract, not a stock account. Interest can be credited from how an index moves. A down year in the index does not, by itself, reduce the contract value. The plain-English version is on Annuities 101. An FIA is built for a long, steady horizon.

• Protection from index losses. The contract value does not decrease because the index falls, subject to the contract terms. A long payout period is less exposed to a bad market at the wrong time.
• Index-linked growth with no cap or spread. The contracts we recommend participate at 100% or more of the index gain. Credits typically reflect index price changes and exclude dividends, and crediting terms can reset at the end of each term.
• No annual contract fee when no riders are elected, so growth is not reduced by an ongoing charge.
• Tax-deferred growth on the balance that stays in the contract while payments are made.
• Predictable payments. Each year’s required amount is based on the balance and the remaining life-expectancy factor.

What “Protection” Really Means

Protection means the contract value is not reduced by index declines. It is not protection from surrender charges (which usually no longer apply once a death claim is paid), from optional rider fees, or from the claims-paying ability of the insurer. Whether index crediting continues during the payout period depends on the carrier.

An Illustration: A $900,000 Inherited Contract

Assume the owner’s $500,000 deposit has grown to $900,000 at death, leaving a $400,000 gain. The beneficiary elects the stretch using an illustrative 40-year life-expectancy factor. The actual factor depends on the beneficiary’s age and the IRS table. Each year’s payment is the balance divided by the remaining years.

Total paid over 40 years: about $900,000 at 0% credits, versus about $2.72 million at a hypothetical 5% annual credit. The 5% figure is not a projection or a promise. Actual credits depend on the index and contract terms and can be zero in any year. In year 1, the $22,500 payment taxed at 25% costs about $5,625, compared with about $100,000 of tax on the $400,000 gain if the beneficiary took a lump sum, before any bracket effect from one large payment.

How the Payments Are Taxed

• Ordinary income, not capital gains. The gain is taxed at the beneficiary’s regular rates. There is no step-up in basis at death.
• The 10% early-withdrawal penalty does not apply to payments made because of the owner’s death.
• Gain-first or exclusion ratio. Some carriers treat stretch payments as withdrawals, taxing gain first. Others treat them as annuity payments, with part of each payment returned tax-free. Ask which method the carrier uses.
• State tax may also apply, depending on where the beneficiary lives.

The goal is not to avoid the tax. It is to decide when the tax is paid, and to let the money keep working in the meantime.

Who Can Use the Stretch?

Steps the Owner Can Take Now

1. Name individuals, with contingents per stirpes. Naming people rather than an estate or trust usually keeps the stretch available. Per stirpes contingents send a deceased beneficiary’s share to that person’s descendants.

2. Ask whether the carrier allows an owner-elected stretch. Some carriers let the owner elect a payout option at death that the beneficiary cannot change. This can steer the money toward income instead of a lump sum.

3. Confirm the beneficiary’s options in writing. Ask how the carrier handles stretch payments, whether crediting continues afterward, and what happens to the remaining balance if the beneficiary dies.

Important Considerations

• Carrier rules vary. The tax code permits the stretch, but each insurer decides which payout options it offers.
• Act within one year. If payments do not begin on time, the five-year rule applies.
• Beneficiary flexibility. Without an owner restriction, a beneficiary may still choose a lump sum.
• Trusts. A trust beneficiary is usually limited to the five-year rule, so any trust planning needs attorney review.
• Qualified accounts differ. IRAs and 401(k)s follow the SECURE Act rules, not these.

Key Terms at a Glance

Questions to Ask the Carrier

• Stretch allowed? Does the contract allow a life-expectancy payout for a non-spouse beneficiary?
• Tax method? Is the stretch taxed gain-first or by exclusion ratio?
• Crediting? Does index crediting continue on the remaining balance?
• Owner election? Can the owner elect a payout option the beneficiary cannot change?
• If the beneficiary passes away? What happens to the balance if the beneficiary dies during the stretch?

If you would like to review how your annuities would be paid to your family, that conversation is complimentary and carries no obligation. Call 317-900-6970 or start a conversation.

About the Author

Ted Byrer, CAS®, is a Retirement Income Specialist and Independent Insurance Agent with Byrer Wealth Management, LLC in Westfield, Indiana. Learn more at Ted Byrer.

This is for educational purposes only and is not legal, tax, or investment advice. Ted Byrer is a licensed insurance professional, not an attorney or tax advisor. It addresses non-qualified annuities only. IRAs and other qualified accounts follow different rules. Payout options, life-expectancy factors, tax treatment, and index crediting during a payout period vary by carrier, contract, and state and may change. Fixed indexed annuity credits depend on contract terms. Participation rates, caps, spreads, surrender charges, and rider fees apply to some contracts or elections. The illustration is hypothetical, is not a projection, and ignores taxes on the payments other than as noted. Guarantees depend on the claims-paying ability of the issuing insurer. Annuities are not a deposit, are not insured by the FDIC or any government agency, and may lose value.